In counseling clients on M&A deals, it is critical to stress transaction nuances that may otherwise serve as an afterthought to a buyer or seller.\u00a0 While both parties reliably demonstrate laser focus on the big picture (i.e., the deal economics), there remain several purchase agreement provisions that can significantly affect a client\u2019s allocation of risk, including representations and warranties, and indemnification provisions.<\/p>\n
First, some quick definitions:<\/p>\n
Example<\/u>: Seller represents and warrants as to certain contracts being valid and binding, in full force and effect, and if there are any consents required in order to assign a specific contract. Therefore, if a contract with a significant customer that has been included in a valuation has expired, or requires consent to assignment, seller is obligated to disclose this expiration or requirement as part of its representations and warranties.\u00a0 Failure to disclose such a material circumstance could prompt a claim for indemnification post-closing.<\/p>\n
Representations and warranties allocate risk between buyer and seller, and serve as the foundation for an indemnification claim in case of a breach or inaccuracy. \u00a0A buyer will push for the representations and warranties to be as broad as possible, while a seller will aspire to narrow the same.<\/p>\n
Claims are most frequently brought by a buyer, who is more likely to suffer a post-closing loss so indemnification typically provides buyer with recourse after the transaction closes.<\/p>\n
One trend I have observed over the past several years concerns the insertion of a concept known as the materiality scrape.<\/p>\n
The aforesaid language actually describes an example of a \u201cdouble\u201d materiality scrape where the parties agree to ignore all materiality qualifications for determining both (A) whether or not a breach occurred, and (B) the amount of indemnifiable losses resulting from the breach.\u00a0 As a compromise, buyer and seller may agree on a \u201csingle\u201d materiality scrape where materiality is disregarded for purposes of determining the amount of indemnifiable losses, but materiality qualifications continue to apply for purposes of determining whether or not a breach occurred.<\/p>\n
Naturally, buyers and sellers heavily negotiate the scope of seller\u2019s representations and warranties, including materiality qualifiers.\u00a0 Sellers push to escape liability for immaterial breaches and immaterial losses.<\/p>\n
Buyers push for materiality scrapes for several reasons, including that purchase agreements often contain language stating buyer may not recover losses for seller\u2019s breaches of representations and warranties until buyer\u2019s total losses exceed a predetermined threshold.\u00a0 These are known as indemnity \u201cbaskets\u201d and buyers will argue for the inclusion of a materiality scrape in order to avoid double materiality issues when such baskets are weaved into the purchase agreement.\u00a0 Sellers will argue that materiality scrapes render their representations and warranties qualifiers useless and that seller will need to disclose everything under the sun through the disclosure schedules.<\/p>\n